The recent wave of equity issues, while not unexpected, raises serious questions. Will investors keep putting up the cash, or will they eventually balk at throwing good money after bad?
Let us recall that during the bull market of 2003-08, it was axiomatic that there was too much equity around. Now nobody wants the stuff, it is equally axiomatic there is too little of it. So much for the laws of supply and demand.
Corporations have played their part with gusto throughout. Through the bull phase they retired mountains of equity, via buy-backs or acquisitions for cash.
This was rationalised as an exercise in arbitrage, based on a torrent of cheap credit. But the upshot is glumly familiar. Having bought equity – their own and others’ – at the top, companies are reduced to selling it at the bottom.
The latter part may prove stubbornly hard. As Citigroup observes, the cult of the equity may have come to the end of its 50-year run, at least for now.
Investors have been battered by two global collapses of 50 per cent in equities in five years. They might be forgiven if they have had enough.
If so, the lack of buyers will mean a higher cost of equity, so that companies will increasingly turn to corporate bonds or to financing themselves internally. They may also, as I separately argued before, turn less to the banks.
Against that, equity has positive virtues from an investor’s perspective. It provides, as Citigroup says, a geared play on economic recovery. It is also a hedge of sorts against inflation. But neither the promise of the first nor the threat of the second weigh heavily with investors at the moment.
Granted, big share issues are being launched in spite of that. But, as in the corporate bond market, cash is available only to those who do not urgently need it. The shares of a more stricken company, from which a cash call is expected, get hammered in advance.
If a share issue is then announced, of course, the share price rallies sharply. This is not the puzzle it seems. A large chunk of risk has been shifted to the underwriters, and it makes sense for other investors to pile in even if they do not intend to take up the issue.
Meanwhile, it is argued by the consultant Andrew Smithers that equities are likely to do badly this year precisely because corporations have turned sellers rather than buyers of their own stock. In the US, he shows a striking correlation during the past decade between the rise and fall of the broad market and corporate purchases.
The direction of causation here is perhaps arguable. Nor does the same correlation hold, for example, in the UK. However, given the dominance of Wall Street on investor sentiment globally, the point seems reasonable.
There is a broader argument, though, which says that, having fallen so far, markets are due to recover anyway. One adherent of that general view is Mr Smithers himself.
The longer you hold equities, he says, the more the volatility of returns falls. This can only result from what he calls negative serial correlation. In the long run, what goes up must come down and vice versa, and the two cancel out.
By comparing returns in recent years with the very long-run average, he calculates that world equities are some 38 per cent underpriced. Within that, the US is if anything still overpriced, and Japan particularly cheap.
But the thinking behind that calculation is explicitly rejected by three London Business School academics, Elroy Dimson, Paul Marsh and Mike Staunton, in their latest annual study of investment returns (sponsored by Credit Suisse).
Mean reversion, they say, scarcely exists in world markets. In concrete terms, as Prof Dimson puts it: “The fact that 2008 was a bad year tells us very little about returns to 2020, or even 2040.”
How are the two views to be reconciled? The difference is that Mr Smithers explicitly uses hindsight to identify market bottoms. But recognising turning-points in real time, as Prof Marsh observes, is quite another matter.
Suppose you bought today and the market then halved before bottoming. However sharp the subsequent recovery, your returns could still look meagre a decade or two away.
Meanwhile, Citigroup hazards a guess that the supply of new equity during the next year or two in Europe alone could be as high as €300bn. Perhaps – but that is not enough to solve the problem.
The paradox is that, in pursuing the cult of equity, companies forgot equity’s real purpose from a corporate standpoint – that is, to provide a cushion in tough times.
They may now have to rebuild that cushion the hard way, rather than relying on investors to do the job for them.
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